Recession-Hard/Soft Landing
Highlights Portfolio Strategy Recession odds continue to tick higher, according to the NY Fed’s probability of recession model, at a time when global growth is waning, U.S. profit growth is contracting and the non-financial ex-tech corporate balance sheet is degrading rapidly. On a cyclical 3-12 month time horizon we remain cautious on the broad equity market. This is U.S. Equity Strategy’s view, which stands in contrast to the more sanguine equity BCA House View. The souring macro backdrop coupled with a firming industry demand outlook signal that more gains are in store for hypermarket stocks. The global growth slowdown, declining real bond yields, missing inflation, rising policy uncertainty and a favorable relative demand backdrop suggest that there is an exploitable tactical trading opportunity in a long global gold miners/short S&P oil & gas E&P pair trade. Recent Changes Upgrade the S&P hypermarkets index to overweight, today. Initiate a long global gold miners/short S&P oil & gas exploration & production (E&P) pair trade, today Table 1 Feature Obsession with the Fed easing continues to trump all else, with the SPX piercing through the 3,000 mark to fresh all-time highs last week. However, it is unrealistic for the Fed to do all the heavy lifting for the equity market as we have argued recently (see Chart 3 from June 24),1 at a time when profit cracks are spreading rapidly. This should be cause for some trepidation. Since the Christmas Eve lows essentially all of the 26% return in equities is explained by valuation expansion. The forward P/E has recovered from 13.5 to nearly 17.2 (Chart 1). There is limited scope for further expansion as four interest rate cuts in the coming 12 months are already priced in lofty valuations. Now profits will have to do the heavy lifting. But on the eve of earnings season, more than half of the S&P 500 GICS1 sectors are forecast to have contracted profits last quarter, and three sectors could not lift revenue versus year ago comps, according to I/B/E/S data. Looking further out, there is a plethora of indicators that we highlighted last week that suggest that a profit recession is looming.2 Our sense is that once the euphoria around the looming Fed easing cycle settles, there will be a massive clash between perception and reality (Chart 2) that will likely propagate as a surge in volatility. Chart 1Multiple Expansion Explains All Of The SPX’s Return Chart 2Unsustainable Divergence This addiction to low rates has come at a great cost to the non-financial corporate sector. As a reminder, this segment of the economy is where the excesses are in the current cycle as we have been highlighting in recent research.3 Using stock market related data for the non-financial ex-tech universe, net debt has increased by 70% to $4.2tn over the past five years, but cash flow has only grown 18% to $1.7tn. As a result, net debt-to-EBITDA has spiked from 1.7 to 2.5, an all-time high (Chart 3). While stocks are at all-time highs (top panel, Chart 3), the debt-saddled non-financials ex-tech universe will likely exert substantial downward pressure to these equities in the coming months (Chart 4). Chart 3Balance Sheet Degrading Chart 4Something’s Got To Give Moving on to the labor market, we recently noticed an interesting behavior between the unemployment rate and wage inflation since the early-1990s recession: a repulsive magnet-type property exists where like magnetic poles repel each other (middle panel, Chart 5). In other words, every time the falling unemployment rate has kissed off accelerating wage growth, a steep reversal ensued at the onset of recession during the previous three cycles. A repeat may be already taking place, as average hourly earnings (AHE) growth has been stuck in the mud since peaking in December 2018. Importantly, the AHE impulse is quickly losing steam and every time the Fed embarks on an aggressive easing cycle it typically marks the end of wage inflation (bottom panel, Chart 5). Chart 5Beware Of Repulsion Chart 6Waiting For Growth Meanwhile, BCA’s global manufacturing PMI diffusion index has cratered to below 40% (middle panel, Chart 6). Neither the G7 nor the EM aggregate PMIs are above the boom/bust line (top panel, Chart 6). Our breakdown of the Leading Economic Indicators into G7 and EM14 also signals that global growth is hard to come by, albeit EMs are showing some early signs of a trough (bottom panel, Chart 6). As the early-May announced increase in Chinese tariffs begin to take a toll, we doubt global growth can have a sustainable recovery for the rest of 2019, despite Chinese credit growth picking up. Now, even Japan and Korea are fighting it out and are erecting barriers to trade, dealing a further blow to these economically hyper-sensitive export-oriented economies. Netting it all out, the odds of recession by mid-2020 continue to tick higher according to the NY Fed’s model (NY Fed’s probability of recession shown inverted, top panel, Chart 5) at a time when global growth is waning, U.S. profit growth is contracting and the non-financial ex-tech corporate balance sheet is degrading rapidly. On a cyclical 3-12 month time horizon we remain cautious on the broad equity market. This is U.S. Equity Strategy’s view, which stands in contrast to the more sanguine equity BCA House View. This week we are upgrading a consumer staples subgroup to overweight and initiating an intra-commodity market neutral trade. Time To Buy The Hype The tide is shifting and we are upgrading the S&P hypermarkets index to an above benchmark allocation. While valuations are stretched, trading at a 50% premium to the overall market on a 12-month forward P/E basis (not shown), our thesis is that these Big Box retailers will grow into their pricey valuations in the coming months. The macro landscape is aligned perfectly with these defensive retailers. Consumer confidence has been falling all year long and now cracks are spreading to the labor market (confidence shown inverted, top panel, Chart 7). ADP small business payrolls declined for the second month in a row. Similarly, the NFIB survey shows that small business hiring plans are cooling (hiring plans shown inverted, middle panel, Chart 7). As a reminder, 2/3 of all new hiring typically occurs in the small and medium enterprise space. In the residential real estate market, the drop in interest rates that is now in its eighth month has yet to be felt, and house price inflation has ground to a halt. Historically, Costco membership growth has been inversely correlated with house prices (house price inflation shown inverted, bottom panel, Chart 7). Chart 7Deteriorating Macro Backdrop … Chart 8…Is A Boon To Hypermarkets… Chart 8 shows three additional macro variables that signal brighter times ahead for the relative share price ratio. The drubbing in the 10-year U.S. treasury yield reflects a souring macro backdrop, melting inflation and a steep fall in U.S. economic data surprises. The ISM manufacturing index that continues to decelerate and is now closing in on the boom/bust line corroborates the bond market’s grim message. Tack on the Fed’s expected four cuts in the coming 12 months, and factors are falling into place for a durable rally in relative share prices. This disinflationary backdrop along with the Fed’s looming easing interest rate cycle have put a solid bid under gold prices. Hypermarket equities and bullion traditionally move in lockstep, and the current message is to expect more gains in the former (top panel, Chart 9). On the trade front specifically, these Big Box retailers do source consumer goods from China, but up to now these imports have been nearly immune to the U.S./China trade dispute as prices have been deflating (import prices shown inverted, bottom panel, Chart 9). However, this does pose a risk going forward and we will be closely monitoring it for two reasons: First, because downward pressures may intensify on the greenback and second, President Trump may impose additional tariffs, both of which are negative for industry pricing power. Chart 9Profit Margins… Chart 10…Will Likely Expand Meanwhile, industry demand is on the rise and will likely offset the potential trade and U.S. dollar induced margin pressures. Hypermarket retail sales are climbing at a healthy clip outpacing overall retail sales (bottom panel, Chart 10). Already non-discretionary retail sales are outshining discretionary ones, which is a precursor to recession at a time when overall consumer outlays have sunk below 1% (real PCE growth shown inverted, top panel, Chart 10). The implication is that hypermarkets will continue to garner a larger slice of consumer outlays as the going gets tough. In sum, the souring macro backdrop coupled with a firming industry demand outlook signal that more gains are in store for hypermarket stocks. Bottom Line: Boost the S&P hypermarkets index to overweight. The ticker symbols for the stocks in this index are: BLBG – S5HYPC – WMT, COST. Initiate A Long Global Gold Miners/Short S&P Oil & Gas E&P Pair Trade One way to benefit from the global growth soft-patch and looming global liquidity injection is to go long global gold miners/short S&P oil & gas E&P stocks on a tactical three-to-six month basis. While this market neutral and intra-commodity pair trade has already enjoyed an impressive run, there is more upside owing to a favorable macro backdrop. The key determinant of this share price ratio is the relative move in the underlying commodities that serve as pricing power proxies (top panel, Chart 11). Given the massive currency debasement potential that has gripped Central Banks the world over, such a flush liquidity backdrop will boost the allure of the shiny metal more so than crude oil. Global manufacturing PMIs are foreshadowing recession and our diffusion index has plummeted to the lowest level since 2011 (diffusion shown inverted, middle panel, Chart 11). In the U.S. specifically there is a growth-to-liquidity handoff and the ISM manufacturing survey’s new order versus prices paid subcomponents confirms that global gold miners have the upper hand compared with E&P equities (bottom panel, Chart 11). Chart 11Global Soft-Patch… Chart 12…Disinflation… As a result of this growth scare that can easily morph into recession especially if the U.S./China trade war continues into next year, inflation is nowhere to be found. Unit labor costs are slumping (top panel, Chart 12), the NY Fed’s Underlying Inflation Gauge has rolled over decisively (not shown),4 and the GDP deflator is slipping (middle panel, Chart 12). Parts of the yield curve first inverted in early-December and the 10-year/fed funds rate slope is still inverted, signaling that gold miners will continue to outperform oil producers (yield curve shown on inverted scale, bottom panel, Chart 13). The near 100bps dive in real interest rates since late-December ties everything together and is a boon to bullion (and gold producers) that yields nothing (TIPS yield shown inverted, top panel, Chart 13). Meanwhile, bond volatility has spiked of late and the bottom panel of Chart 14 shows that historically the MOVE index has been joined at the hip with relative share prices. Chart 13…Melting Real Yields And… Chart 14…The Spike In Bond Vol, All Favor Gold Miners Over Oil Producers On the relative demand front, we peer over to China to take a pulse of the marginal moves in these commodity markets. China (and Russia) has been aggressively shifting their currency reserves into gold, and bullion holdings are rising both in volume terms and as a percentage of total FX reserves. In marked contrast, oil demand is feeble and Chinese apparent diesel consumption that is closely correlated with infrastructure and manufacturing activity has tumbled. Taken together, the message is to expect additional gain in relative share prices (middle & bottom panels, Chart 15). Adding it all up, the global growth slowdown, declining real bond yields, missing inflation, rising policy uncertainty and a favorable relative demand backdrop suggest that there is an exploitable tactical trading opportunity in a long global gold miners/short S&P oil & gas E&P pair trade. Bottom Line: Initiate a tactical long global gold miners/short S&P oil & gas E&P pair trade on a three-to-six month time horizon with a stop at the -10% mark. The ticker symbols for the stocks in these indexes are: GDX:US and BLBG – S5OILP – COP, EOG, APC, PXD, CXO, FANG, HES, DVN, MRO, NBL, COG, APA, XEC, respectively. Chart 15Upbeat Relative Demand Backdrop Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com Footnotes 1 Please see BCA U.S. Equity Strategy Weekly Report, “Cracks Forming” dated June 24, 2019, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, “Beware Profit Recession” dated July 8, 2019, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, “A Recession Thought Experiment” dated June 10, 2019, available at uses.bcaresearch.com. 4 https://www.newyorkfed.org/research/policy/underlying-inflation-gauge Current Recommendations Size And Style Views Favor value over growth Favor large over small caps
Dear Client, In lieu of next week’s regular report, we will be bringing you a Special Report featuring a no-holds-barred debate over the economic and financial market outlook among three of BCA’s more bullish strategists (Doug Peta, Rob Robis, and yours truly) and three of the more bearish ones (Anastasios Avgeriou, Arthur Budaghyan, and Dhaval Joshi). Best regards, Peter Berezin, Chief Global Strategist Highlights Slowdowns are much more likely to turn into recessions when significant economic and financial imbalances are present. The U.S. does not currently suffer from any of the three major imbalances that have historically heralded recessions – rapid private-sector debt growth; excessive spending in cyclical sectors such as housing, consumer durables, and business capex; or accelerating inflation. Imbalances are larger abroad, but not to the extent that they will trigger a global recession. The combination of ongoing Chinese stimulus and the lagged effect from lower bond yields will lift global growth during the coming months. The inventory cycle, which is likely to subtract at least one full percentage point from U.S. growth in Q2, will also turn from being a headwind to a tailwind. Stay overweight global equities relative to government bonds over the next 12 months. A rebound in global growth will push down the U.S. dollar later this year, creating an opportunity to increase exposure to European and EM equities. Feature Global Growth At A Critical Juncture The global economy has clearly slowed since early 2018 (Chart 1). So far, much of the weakness has been confined to the manufacturing sector. However, the service sector has softened as well (Chart 2). Chart 1The Global Economy Has Slowed... Chart 2...Mostly Due To Another Manufacturing Downturn Regionally, the U.S. has held up somewhat better than most other economies. Nevertheless, the ISM manufacturing and nonmanufacturing indices have both declined, with the former now flirting with the 50 line. All recessions begin as slowdowns but not all slowdowns end in recessions. As we discuss below, slowdowns are much more likely to morph into recessions when financial and economic imbalances are elevated. We confine our empirical analysis to the U.S., but discuss the global context later in the report. Three Key Recessionary Imbalances Three imbalances, in particular, have often been present at the outset of U.S. recessions (Chart 3): Chart 3What Makes A Slowdown Degenerate Into A Recession: Imbalances Rapid private-sector debt growth: Rising debt lifts aggregate demand.1 Fast debt growth is also often associated with bad lending decisions, which makes economies more vulnerable to adverse shocks. An unsustainably high level of cyclical spending: Cyclical spending includes business and residential investment, as well as spending on consumer durable goods. If spending on these categories is elevated, there is more scope for it to decline when the economy turns down. High and rising inflation. When inflation rises above the Fed’s comfort zone, the central bank normally needs to raise rates into restrictive territory. Fast debt growth is also often associated with bad lending decisions, which makes economies more vulnerable to adverse shocks. Table 1 shows every episode since 1960 when the U.S. economy has slowed significantly. To keep things simple, we define a slowdown as a 10-point drop in the ISM manufacturing index from its recent high. Table 1Episodes Of Significant Economic Slowdown Of the 15 slowdowns that we examined, seven culminated in recessions. An average of 2.1 of the three imbalances listed above were visible prior to recessions. However, an average of only 0.9 imbalances were present when a recession failed to materialize. This supports our claim that slowdowns are more likely to turn into recessions when significant imbalances are present. The good news for the U.S. is that it currently does not register any of three imbalances that have typically preceded recessions. Equities reacted very differently in the two cases. When a recession did occur following the start of a slowdown, the S&P 500 declined by an average of 3.6% over the subsequent 12 months. When the slowdown failed to turn into a recession, the S&P rose by an average of 18.3%. In the latter case, the recovery in stocks usually coincided with a swift rebound in the ISM index. The U.S. Is Currently 0 For 3 On The Imbalance Front The good news for the U.S. is that it currently does not register any of three imbalances that have typically preceded recessions. Chart 4Reasons Not To Panic About U.S. Corporate Debt (I) Private-Sector Debt While U.S. private nonfinancial debt has edged up slightly as a share of GDP since 2015, it remains well below its 2008 peak. In fact, the current business expansion is the only one in the post-war era where private-sector debt has failed to rise above its previous cycle high. A recent Bank of England study examined 130 recessions across 26 countries. It found private debt growth matters much more for recession risk than the level of debt.2 Granted, the composition of debt also matters: While household debt in the U.S. has fallen over the past decade, corporate debt has risen. As a share of GDP, corporate debt is now at the highest level in the post-war era. That said, despite its recent ascent, the ratio of corporate debt-to-GDP is less than two percentage points higher than it was in 2008. One drawback of comparing debt to GDP is that the former is a stock variable while the latter is a flow variable. A more sensible “apples-to-apples” approach is to look at corporate debt in relation to assets rather than GDP. If one does that, one sees that the ratio of U.S. corporate debt-to-assets is below its post-1980 average and only slightly above its post-1950 average. The interest coverage ratio, which compares the profits that companies earn for every dollar of interest that they pay, is above its historic norm (Chart 4). Corporate sector free cash flow – the difference between profits and spending on such things as labor and capital goods – remains in surplus. Every recession during the past 50 years has begun when the free cash flow balance was in deficit (Chart 5). In contrast to mortgages, which are generally held by leveraged institutions such as banks, most corporate debt is held by entities such as insurance companies, pension funds, mutual funds, and ETFs. Banks hold only 18% of corporate debt, down from 40% in 1980 (Chart 6). Thus, while high corporate debt levels could exacerbate the next recession, they are unlikely to engender it. Chart 5Reasons Not To Panic About U.S. Corporate Debt (II) Chart 6Banks Have Reduced Their Exposure To The Corporate Sector Cyclical Spending Unlike a restaurant meal or a vacation, a house, office tower, factory, or automobile will usually retain some value for a while after it is purchased. If spending on cyclical items rises to a high level for an extended period of time, a glut will form, requiring a period of lower production. By contrast, if spending on these items is subdued for a long time, pent-up demand will accumulate, requiring a period of higher production. Recessions can result from either economic overheating or financial market overheating. As a share of GDP, cyclical spending is still far below the peaks observed during past expansions. Just as importantly, today’s low level of cyclical spending follows ten years of even lower spending. As a result, the average age of the U.S. capital stock has increased across almost all categories since 2008 (Chart 7). Most notably, the average age of U.S. homes has risen by nearly five years since 2006, the sharpest increase since the Great Depression. Despite the rebound in residential investment from its recessionary lows, the current level of homebuilding still falls short of what is necessary to keep up with household formation. As a consequence, the vacancy rate has fallen to multi-decade lows (Chart 8). Chart 7The Capital Stock Is Aging Chart 8There Is No Glut Of U.S. Homes Inflation Recessions can result from either economic overheating or financial market overheating. Economic overheating was the dominant driver of recessions between the late 1960s to early 1980s. Rising inflation preceded the recessions of 1969-70, 1973-75, as well as the back-to-back recessions in 1980-82. Chart 9The 1990 Recession: A Bit Of Everything Overheating also contributed to the 1990 recession. After peaking in 1982, the unemployment rate fell to 5% in 1989, about one percent below its equilibrium level at the time. Core inflation began to accelerate, reaching 5.5% by August 1990. The Fed initially responded to the overheating economy by hiking interest rates. The fed funds rate rose from 6.6% in March 1988 to a high of 9.8% by May 1989. By the summer of 1990, the economy had already slowed significantly. Commercial real estate, still reeling from the effects of the Savings and Loan crisis, weakened sharply. Defense outlays continued to contract following the collapse of the Soviet Union. The final straw was Saddam Hussein’s invasion of Kuwait, which caused oil prices to surge and consumer confidence to plunge (Chart 9). In contrast to earlier downturns, the last two recessions were more the byproduct of financial excesses: The 2007-09 recession stemmed from the housing crash and the financial crisis it generated; the 2001 recession followed the dotcom bust, which precipitated a steep decline in capital spending. What will the next U.S. recession look like? Given the absence of major financial imbalances, the odds are high that the next recession will be a “retro recession,” featuring classic economic overheating. The fact that the Fed has adopted a risk-based approach to monetary policy, which puts great weight on avoiding a deflationary outcome, only raises the likelihood that inflation will eventually move higher. The good news is that this is unlikely to happen anytime soon. While wage growth has picked up, productivity growth has risen even more. As a result, unit labor costs – the ratio of wages-to-productivity – have actually decelerated over the past 18 months. Unit labor cost inflation tends to lead core inflation by up to one year (Chart 10). Given the absence of major financial imbalances, the odds are high that the next recession will be a “retro recession,” featuring classic economic overheating. As we discussed in our latest Strategy Outlook, the Fed will probably not bring rates into restrictive territory until early 2022. This gives the economy plenty of breathing space.3 The Global Dimension The discussion above has focused on the United States. To some extent, this is unavoidable. Not only is the U.S. still the world’s largest economy, but it remains at the heart of the global financial system. U.S. equities account for over half of global stock market capitalization, up from a third in the early 1990s (Chart 11). The dollar continues to be the preeminent reserve currency. As a result, U.S. financial markets drive overseas markets much more than the other way around. Chart 10No Imminent Threat Of A Wage-Price Inflationary Spiral Chart 11The U.S. Stock Market Capitalization Is More Than Half Of Global This does not mean that the rest of the world is irrelevant. The global supply chain now dominates international trade. More than half of all cross-border trade is in intermediate goods (Chart 12). Irrespective of the financial and economic imbalances discussed above, a full-blown trade war would upend the global economy, sending the U.S. and the rest of the world into recession. President Trump’s re-election prospects would plummet if U.S. unemployment rose and the stock market plunged. This is the main reason for thinking that the trade talks will ultimately produce some sort of détente. Nevertheless, a severe deterioration of trade relations remains the biggest risk to our bullish view on risk assets. The fact that financial and economic imbalances are generally larger overseas means that the rest of the world is more vulnerable to adverse shocks. Unlike in the United States, private debt has risen sharply as a share of GDP in several key economies over the past decade (Chart 13). Government debt is also a problem in countries such as Italy that do not have central banks which can function as reliable lenders of last resort. Chart 14Economies With Frothy Housing Markets Risk Having Deeper Downturns Cyclical spending is fairly elevated in a number of countries. Notably, residential investment stands at near record highs as a share of GDP in Canada, Australia, and New Zealand (Chart 14). Home prices are also quite frothy there. When the global economy falls into recession in two-to-three years, these economies will take it on the chin. Investment Conclusions Notwithstanding the risks noted above, we continue to maintain a bullish outlook on global equities and spread product over the next 12 months. To paraphrase Wayne Gretzky, one should invest on the basis of where the economic data is going, not where it is.4 While global growth remains anemic today, the combination of Chinese stimulus and the lagged effect from lower bond yields will boost activity during the coming months. The inventory cycle, which is likely to subtract at least one full percentage point from U.S. growth in Q2, will also turn from being a headwind to a tailwind. Global equities are not super cheap, but they are not particularly expensive either. The MSCI All-Country World Index trades at 15.3-times forward earnings. Given the ultra-low level of global bond yields, this generates an equity risk premium (ERP) that is well above its historical average (Chart 15). From an asset allocation perspective, one should favor stocks over bonds when the ERP is high. Chart 15AEquity Risk Premia Remain Elevated (I) Chart 15BEquity Risk Premia Remain Elevated (II) The ERP is especially elevated outside the United States. This is partly because non-U.S. stocks trade at a meager 13.3-times forward earnings, but it also reflects the fact that bond yields are lower overseas. The fact that financial and economic imbalances are generally larger overseas means that the rest of the world is more vulnerable to adverse shocks. As global growth accelerates, the dollar will start to weaken (Chart 16). EM and European equities usually outperform the global benchmark in that environment (Chart 17). We expect to upgrade stocks in these regions later this summer. Chart 16The Dollar Is A Countercyclical Currency Chart 17EM And Euro Area Equities Outperform When Global Growth Improves Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1 Recall that GDP is a flow variable (how much production takes place every period), whereas credit is a stock variable (how much debt there is outstanding). By definition, a flow is a change in a stock. Thus, credit growth affects GDP and the change in credit growth affects GDP growth. 2 Jonathan Bridges, Chris Jackson, and Daisy McGregor, "Down in the slumps: the role of credit in five decades of recessions," Bank Of England Staff Working Paper No. 659, (April 2017). 3 Please see Global Investment Strategy Strategy Outlook, "Third Quarter 2019 Strategy Outlook: The Long Hurrah," dated June 28, 2019. 4 According to Wayne Gretzky, his father, Walter, once advised him to “skate to where the puck is going, not to where it is.” Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades
Highlights Chart 1Looks Like 2016 & 1998 The Treasury market continues to price-in a recession-like outcome for the U.S. economy, embedding 83 basis points of Fed rate cuts over the next 12 months. But last week’s economic data challenge that narrative. First, the ISM Non-Manufacturing PMI held above 55 in June, even as its Manufacturing counterpart plunged toward the 50 boom/bust line (Chart 1). This divergence between a strong service sector and weak manufacturing sector is more reminiscent of prior mid-cycle slowdowns in 2016 and 1998 than of any pre-recession period. Second, nonfarm payrolls added 224k jobs in June, a strong rebound from the 72k added in May and enough to keep the 12-month growth rate at a healthy 1.5% (bottom panel). Still-low inflation expectations provide sufficient cover for the Fed to cut rates later this month, likely by 25 bps. But beyond that, continued strong economic data could prevent any further easing. Keep portfolio duration low and stay short the February 2020 fed funds futures contract. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 144 basis points in June, bringing year-to-date excess returns up to +368 bps. We removed our recommendation to hedge near-term corporate credit exposure after the Fed’s clear dovish pivot at the June FOMC meeting.1 At that time, we also noted that the surging gold price, weakening trade-weighted dollar and outperformance of global industrial mining stocks were all signaling that corporate spreads have peaked (Chart 2). Of our “peak credit spread” indicators, only the CRB Raw Industrials index has yet to turn the corner. The macro environment supports tighter spreads. But in the investment grade space, value only looks attractive for Baa-rated securities. Baa spreads remain 7 bps above our target (panel 3), while Aa and A-rated spreads are 1 bp and 4 bps below, respectively (panel 4). Aaa bonds are even more expensive, with spreads 19 bps below target (not shown).2 Investors should focus their investment grade corporate bond exposure on Baa-rated securities. Our measure of gross leverage – total debt over pre-tax profits – jumped in Q1, as corporate debt grew at an annualized pace of 8.5% while corporate profits contracted by an annualized 18% (bottom panel). Leverage will likely rise again in Q2, as profit growth will almost certainly remain weak, but should then level-off as global growth recovers. High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 154 basis points in June, bringing year-to-date excess returns up to +603 bps. The average index option-adjusted spread tightened 56 bps on the month. At 366 bps, it remains well above the cycle-low of 303 bps. As with investment grade credit, we removed our recommendation to hedge near-term exposure following the June FOMC meeting (see page 3). Further, we see the potential for much more spread tightening in high-yield than in investment grade. Within investment grade, only the Baa credit tier carries a spread above our target. In High-Yield, Ba-rated spreads are 42 bps above our target (Chart 3), B-rated spreads are 108 bps above our target (panel 3) and Caa-rated spreads are 263 bps above our target (not shown).3 Junk spreads also offer reasonable value relative to expected default losses. The current Moody’s baseline forecast calls for a default rate of 2.7% over the next 12 months, not far from our own projection.4 This would translate into 224 bps of excess spread in the High-Yield index, after adjusting for default losses (panel 4). This is comfortably above zero, and only just below the historical average of 250 bps. We will continue to monitor job cut announcements, which have moderated so far this year (bottom panel), and C&I lending standards, which remain in net easing territory, to assess whether our default expectations need to be revised. MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 2 basis points in June, bringing year-to-date excess returns up to -11 bps. The conventional 30-year zero-volatility spread widened 1 bp on the month, as a 4 bps widening in the option-adjusted spread (OAS) was partially offset by a 3 bps decline in the compensation for prepayment risk (option cost). Falling mortgage rates hurt MBS in the first half of this year, as lower rates led to an increase in refi activity that drove MBS spreads wider (Chart 4). In fact, the conventional 30-year index OAS has risen all the way back to its average pre-crisis level (panel 3). However, as we noted in last week’s report, the nominal 30-year MBS spread remains very tight, at close to one standard deviation below its historical mean.5 The mixed valuation picture means we are not yet inclined to augment our recommended allocation to MBS, especially given the favorable environment for corporate bonds, where expected returns are higher. We are equally disinclined to downgrade MBS, given that refi activity could be close to peaking. All in all, we expect that the next move in the MBS/Treasury basis will be a tightening, as global growth improves and mortgage rates rise in the second half of the year. However, valuation is not sufficiently attractive to warrant more than a neutral allocation. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 26 basis points in June, bringing year-to-date excess returns up to +133 bps. Sovereign debt outperformed duration-equivalent Treasuries by 208 bps on the month, bringing year-to-date excess returns up to +419 bps. Local Authorities underperformed the Treasury benchmark by 6 bps, dragging year-to-date excess returns down to +213 bps. Meanwhile, Foreign Agencies underperformed by 26 bps, dragging year-to-date excess returns down to +103 bps. Domestic Agencies underperformed by 4 bps in June, dragging year-to-date excess returns down to +25 bps. Supranationals outperformed by 1 bp on the month, bringing year-to-date excess returns up to +28 bps. Sovereign debt remains very expensive relative to equivalently rated U.S. corporate credit (Chart 5). While the sector would benefit if the Fed’s dovish pivot results in a weaker dollar, U.S. corporate bonds would still outperform in that scenario, given the more attractive starting point for spreads. We continue to recommend an underweight allocation to Sovereigns. Unlike the debt of most other countries, Mexican sovereign bonds continue to trade cheap relative to U.S. corporates (bottom panel). While this remains an attractive option from a valuation perspective, the President’s on again/off again tariff threats make it a risky near-term proposition. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 73 basis points in June, dragging year-to-date excess returns down to -44 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury yield ratio rose 2% in June, and currently sits at 81% (Chart 6). The ratio is close to one standard deviation below its post-crisis mean, but exactly equal to the average that prevailed in the late stages of the previous cycle, between mid-2006 and mid-2007. Recent muni underperformance has been broad-based across the entire maturity spectrum, but long-end (20-year and 30-year) yield ratios continue to look attractive relative to the rest of the curve. 20-year and 30-year Aaa-rated yield ratios are more than one standard deviation above their respective pre-crisis averages. Meanwhile, 10-year, 5-year and 2-year Aaa yield ratios are very close to average pre-crisis levels. State & local government balance sheets are in decent shape and a material increase in ratings downgrades is unlikely (bottom panel). We therefore recommend an overweight allocation to municipal bonds, but with a preference for 20-year and 30-year Aaa-rated securities. We showed in a recent report that value declines sharply if you move into shorter maturities or lower credit tiers.6 Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview The Treasury curve bull-steepened in June, alongside a large drop in our 12-month Fed Funds Discounter from -75 bps to -90 bps (Chart 7). June’s bull-steepening was reversed last week, as the strong employment report caused our discounter to jump back up to -83 bps, resulting in a bear-flattening of the Treasury curve. All in all, the 2/10 Treasury slope steepened 6 bps in June, then flattened 8 bps in the first week of July. It currently sits comfortably above zero at 17 bps. The 5/30 slope steepened 11 bps in June, then flattened 6 bps last week. It currently sits at 70 bps. In last week’s report we reviewed the case for barbelling your U.S. bond portfolio.7 That is, favoring the short and long ends of the yield curve while avoiding the 5-year and 7-year maturities. This positioning continues to make sense. Not only does the barbell increase the average yield of your portfolio, but our butterfly spread models all show that barbells are cheap relative to bullets (see Appendix B). The 5-year and 7-year yields will also rise more than long-end and short-end yields when the market eventually moves to price-in fewer Fed rate cuts. In addition to our recommended barbell positioning, we advocate keeping a short position in the February 2020 fed funds futures contract. That contract is currently priced for a fed funds rate of 1.69% next February, the equivalent of three 25 basis point rate cuts spread over the next five FOMC meetings. The Fed is unlikely to deliver that much easing. TIPS: Overweight Chart 8Inflation Compensation TIPS underperformed the duration-equivalent nominal Treasury index by 11 basis points in June, dragging year-to-date excess returns down to +28 bps. The 10-year TIPS breakeven inflation rate fell 5 bps on the month and currently sits at 1.69% (Chart 8). The 5-year/5-year forward TIPS breakeven inflation rate fell 4 bps on the month and currently sits at 1.83%. As we have noted in recent research, FOMC members are monitoring long-dated inflation expectations and are committed to keeping policy easy enough to “re-anchor” them at levels consistent with the Fed’s 2% target.8 In the long-run, this will support a return of long-dated TIPS breakeven inflation rates (both 10-year and 5-year/5-year forward) to our 2.3% - 2.5% target range. However, for breakevens to move higher, investors will also need to see evidence that realized inflation can be sustained near 2%. On that note, the core PCE deflator grew at a healthy 2.3% (annualized) clip in May, following an even higher 3% (annualized) rate in April. However, it has only grown 1.6% during the past year. 12-month trimmed mean PCE is running almost exactly in line with the Fed’s target at 1.99%. In a recent report we noted that 12-month core PCE inflation has a track record of converging toward the trimmed mean.9 ABS: Underweight Chart 9ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 13 basis points in June, dragging year-to-date excess returns down to +51 bps. The index option-adjusted spread for Aaa-rated ABS widened 9 bps on the month, moving back above its minimum pre-crisis level (Chart 9). At 36 bps, the spread remains well below its pre-crisis mean of 64 bps. In addition to poor valuation, the sector’s credit fundamentals are shifting in a negative direction. Household interest payments continue to trend up, suggesting a higher delinquency rate going forward (panel 3). Meanwhile, the Fed’s Senior Loan Officer Survey revealed that average consumer lending standards tightened in Q1 for the second consecutive quarter. Tighter lending standards usually coincide with rising consumer delinquencies (bottom panel). Loan officers also reported slowing demand for credit cards for the fifth consecutive quarter, and slowing auto loan demand for the third consecutive quarter. Second quarter data will be made available in early August, but current trends are not promising. The combination of poor value and deteriorating credit quality leads us to recommend an underweight allocation to consumer ABS. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 4 basis points in June, dragging year-to-date excess returns down to +191 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 2 bps on the month. It currently sits at 68 bps, below its average pre-crisis level but above levels seen in 2018 (Chart 10). The macro outlook for commercial real estate looks somewhat unfavorable, with lenders tightening standards (panel 4) amidst falling demand (bottom panel). However, on a positive note, commercial real estate prices recently accelerated and are now much more consistent with current CMBS spreads (panel 3). Despite the mixed fundamental picture, CMBS still offer excellent compensation relative to other similarly-rated fixed income sectors.10 Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 3 basis points in June, bringing year-to-date excess returns up to +93 bps. The index option-adjusted spread widened 1 bp on the month and currently sits at 50 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer high potential return compared to other low-risk spread products. An overweight allocation to this defensive sector remains appropriate. Appendix A - The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. Chart 11The Golden Rule's Track Record At present, the market is priced for 83 basis points of cuts during the next 12 months. We do not anticipate any rate cuts during this timeframe, and therefore recommend that investors maintain below-benchmark portfolio duration. We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Appendix B - Butterfly Strategy Valuation The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com U.S. Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As of July 5, 2019) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As of July 5, 2019) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of +56 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 56 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C - Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Map employs volatility-adjusted breakeven spread analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Map does not incorporate any macroeconomic view. The horizontal axis of the Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps of excess return. Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy / Global Fixed Income Strategy Weekly Report, “The Fed’s Got Your Back”, dated June 25, 2019, available at usbs.bcaresearch.com 2 For more details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 3 For more details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Special Report, “Assessing Corporate Default Risk”, dated March 19, 2019, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “The Long Awkward Middle Phase”, dated July 2, 2019, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “Full Speed Ahead”, dated April 16, 2019, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, “The Long Awkward Middle Phase”, dated July 2, 2019, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, “The New Battleground For Monetary Policy”, dated March 26, 2019, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, “Hedge Near-Term Credit Exposure”, dated May 28, 2019, available at usbs.bcaresearch.com 10 Please see U.S. Bond Strategy Weekly Report, “The Search For Aaa Spread”, dated March 12, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation
Highlights Portfolio Strategy Business sector selling price inflation is sinking like a stone following the bond market’s melting inflation expectations, at a time when wage inflation continues to expand smartly. There are good odds that profit margins have already peaked for the cycle, and we reiterate our cyclically cautious overall equity market view. The souring global macro backdrop, rising policy uncertainty, melting real yields and a stampede into bonds all signal that it still pays to hold global gold miners as a portfolio hedge. Three key defense manufacturers’ demand drivers – global rearmament, a space race and cyber security – remain upbeat and will continue to underpin relative industry profitability. Recent Changes There are no changes to the portfolio this week. Table 1 Feature The SPX fell from all-time highs last week on the eve of the G20 Trump-Xi meeting, the outcome of which will dominate trading this week. The “three hopes” rally, as we have coined it predicated upon a U.S./China trade deal, Chinese massive reflation and a fresh Fed easing cycle, is at risk of disappointment as all the good news is likely already priced into stocks. Stocks may suffer a buy the rumor sell the news setback as they did back in early-December right after the Argentina G20 meeting. Following up from last week’s charts 3-6 that generated higher-than-usual responses from clients, we were encouraged to broaden out these eighteen indicators and try to include some positive ones as it appeared that we may be cherry picking the data.1 Put differently, there must be some economic data series that would offset the grim U.S. macro backdrop we painted and likely aid the Fed in its looming easing cycle. This week we update our corporate pricing power table, highlight a safe haven materials subgroup, and an industrials bulletproof subindex. With regard to the 2018 stock market related fiscal easing boost, neither corporate tax rates would drop further in 2019 nor would buybacks hit the $1tn mark this year. Already, the Standard & Poor’s reported preliminary data that showed buybacks contracted sequentially by 7.7% in Q1/2019 (top panel, Chart 1).2 Retail sales and personal consumption expenditures (PCE) are indeed expanding, however retail sales have decelerated lately (top & second panels, Chart 2). In contrast, consumer sentiment and consumer confidence are contracting on a year-over-year (yoy) basis and the U.S. leading economic indicator is steeply decelerating near 2%/annum from almost 7% at the beginning of the year (middle, fourth & bottom panels, Chart 2). Chart 1Buybacks Are Decelerating Chart 2Retail Sales And PCE Are Expanding The mortgage application purchase index is gaining momentum courtesy of the 125bps drop in interest rates over the past eight months. But, equity market internals suggest that some of these applications may not convert into home sales: relative homebuilders share price momentum is contracting (Chart 3). As a reminder we recently monetized relative gains of 10% in the S&P homebuilding index, since inception.3 Sticking with housing, new median single family home prices remain 10% below their 2017 zenith, and the Case-Shiller 20-city index growth rate hit the zero line recently on a month-over-month basis. New home sales are in contraction territory (Chart 4). Chart 3Are Cracks Forming… Chart 4…In The Housing Market? On the labor front, while the unemployment rate and unemployment insurance claims are both at generationally low levels, it will be extremely difficult for either of these labor market series to fall significantly from current levels. In contrast, there are rising odds that the deteriorating credit quality backdrop will soon infect the labor market (top & second panels, Chart 5). Already, “jobs are hard to get” confirming that the unemployment rate cannot fall much further from current levels (middle panel, Chart 5). Not only is credit quality deteriorating at the margin, but also loan growth is decelerating with our credit impulse diffusion indicator falling below the boom/bust line (fourth & bottom panels, Chart 5). U.S. manufacturing, the most cyclical part of the U.S. economy, is under intense pressure. The U.S./China trade tussle is the culprit. Industrial production and capacity utilization petered out last year in September and November, respectively (top & second panels, Chart 6). Chart 5Could The Labor Market Sour Next? Chart 6Manufacturing Has No… Chart 7…Pulse Durable goods orders are not showing any signs of a turnaround with overall orders flirting with the zero line and core orders contracting (third panel, Chart 6). Total business sales-to-inventories are stuck in the contraction zone (bottom panel, Chart 6). Manufacturing survey data series are all in a synchronous meltdown. Seven regional Fed manufacturing surveys are all sinking (Chart 7). Such broad-based weakness bodes ill for the upcoming ISM manufacturing survey print (we went to print on Friday after the market close, and as a reminder we observed Canada Day yesterday). The ISM manufacturing new orders-to-inventories ratio sits right at one, warning that more profit trouble looms for the SPX (bottom panel, Chart 1). Keep in mind that typically the ISM manufacturing survey pulls down the ISM services one, as the former represents the most cyclical parts of the U.S. economy. Both are currently contracting on a yoy basis (Chart 8). Adding it all up, the negative economic data clearly dominate and only a handful of data series remain standing. The final tally on these indicators is fifteen negative and five positive (Chart 9). We are still awaiting a turn in the majority of the data to confirm the economy is on a solid footing. Chart 8ISM Services Survey Is Contracting Chart 10Heed The Message From The GS Current Activity Indicator Goldman Sachs’ Current Activity Indicator (GSCAI, a first principal component of 37 weekly and monthly data series) does an excellent job in capturing all these forces. Currently, the GSCAI is steeply decelerating, warning that SPX profit growth will surprise to the downside in coming quarters (top panel, Chart 10). Thus, we reiterate that a cyclically (3-12 month horizon) cautious equity market stance is still warranted. This is U.S. Equity Strategy’s view, which stands in contrast to the sanguine equity BCA House View. This week we update our corporate pricing power table, highlight a safe haven materials subgroup, and an industrials bulletproof subindex. Corporate Pricing Power Update U.S. Equity Strategy’s corporate sector pricing power proxy has sunk further since our last update three months ago, and is now deflating 1.1%/annum. Chart 11 shows that the last time the business sector was mired in deflation was during the 2015/16 manufacturing recession. Chart 11Profit Margin Trouble To Persist However, the big difference between now and 2015/16 is that wages are currently expanding at a healthy clip, warning that the corporate sector margin squeeze will not abate any time soon. Granted, unit labor costs are indeed contracting on the back of a surge in productivity, and may thus provide a partial offset. SPX margins have been contracting for two consecutive quarters and sell-side analysts forecast that they will contract for another two. Our margin proxy corroborates this grim sell-side profit margin expectation, and similar to the 2015/2016 episode is firing a margin squeeze warning shot (bottom panel, Chart 11). Digging beneath the surface, our corporate pricing power proxy is revealing. As a reminder, we calculate industry group pricing power from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. Table 2 also highlights shorter term pricing power trends and each industry's spread to overall inflation. Two thirds of the industries we cover are lifting selling prices, but only a quarter are raising prices at a faster clip than overall inflation. On a selling price inflation trend basis, 81% of the industries we cover are either flat or in a downtrend (Table 2). Table 2Industry Group Pricing Power There is only one commodity-related industry in the top ten, a sea change from our late-March update when the commodity complex dominated the top ranks occupying six spots (Table 2). Interestingly, industrials have a healthy showing in the top sixteen spots with five entries. On the flip side, energy-related industries continue to populate the bottom of the ranks as WTI crude oil is still deflating from the October 2018 peak. In sum, business sector selling price inflation is sinking like a stone following the bond market’s melting inflation expectations, at a time when wage inflation continues to expand smartly. There are good odds that profit margins have already peaked for the cycle, and we reiterate our cyclically cautious overall equity market view. In sum, business sector selling price inflation is sinking like a stone following the bond market’s melting inflation expectations, at a time when wage inflation continues to expand smartly. There are good odds that profit margins have already peaked for the cycle, and we reiterate our cyclically cautious overall equity market view. Glittering Gold On March 4th, 2019 we reiterated our view that it still made sense to hold an above benchmark allocation to gold equities as a portfolio hedge.4 While our overweight position is in the red since inception, it has recouped 15% versus the broad market since our early-March update, and more gains are in store in the coming months. When global growth is in retreat investors bid up the price of the safe-haven shiny metal which in turn pulls global gold miners higher. The opposite is also true. Chart 12 shows this inverse relationship gold mining equities have with global growth. In more detail, relative share prices move inversely with the global manufacturing PMI (PMI shown inverted, Chart 12). Chart 12Gold Miners Benefit From… Currently, economists, tracked by Bloomberg, have been aggressively decreasing their estimates for 2019 global real GDP growth, down 50bps year-to-date to 3.3% (bottom panel, Chart 13). Similarly, the global ZEW economic sentiment survey has collapsed to levels last hit during the great recession (top panel, Chart 14). Chart 13…Global Growth… Chart 14…Slowdown Tack on the sustained increase in global policy uncertainty with trade wars, Iranian sanctions, Brexit and Italian politics to name a few, and global gold miners are in the pole position (top panel, Chart 13). As a result, global equity risk premia have come out of hibernation and signal that the gold mining rally has more legs (middle panel, Chart 14). This souring global macro backdrop has dealt a blow to global real yields that are melting. Given that gold equities sport a low dividend yield, they are primary beneficiaries of this disinflationary global economic backdrop (real yield shown inverted, middle panel, Chart 13). Chart 15Negative Yielding Bonds Boost Global Gold Miners Meanwhile, investors have been piling into global bonds and currently negative yielding bonds have surpassed the $13tn mark. Such a stampede into negative yielding bonds has been a boon to global gold mining stocks (Chart 15). This investor risk aversion is also evident in the total return stock-to-bond (S/B) ratio: bonds have been outperforming equities since late-September 2018. Since the early 1990s, relative share prices have been moving in the opposite direction of the S/B ratio, and the current message is to expect more gains in the former (S/B ratio shown inverted, Chart 16). Chart 16When Bonds Outperform Stocks, Buy Gold Miners Chart 17A Tad Overbought, But Still Cheap Meanwhile, the Fed is about to embark on an easing cycle courtesy of a softening economic backdrop and any insurance interest rate cuts will likely put a further dent in the dollar. The upshot is that gold is priced in U.S. dollars similar to the broad commodity complex and tends to rise in price when the greenback depreciates and vice versa. A lower trade-weighted dollar will also boost relative share prices (U.S. dollar shown inverted, bottom panel, Chart 14). Finally, while relative share prices are slightly overbought, relative valuations remain in the neutral zone (Chart 17). In sum, the souring global macro backdrop, rising policy uncertainty, melting real yields and a stampede into bonds all signal that it still pays to hold global gold miners as a portfolio hedge. Bottom Line: We remain overweight the global gold mining index. The ticker symbol for the global gold mining exchange traded fund is: GDX: US. Defense Delivers Recent M&A news in the aerospace & defense sector with UTX bidding for RTN was initially cheered by investors, but President Trump signaled that such a deal would decrease competition in the sector and U.S. regulators would block it. Irrespective of the outcome of this deal, we remain overweight the pure-play BCA Defense Index on a structural basis and also reiterate its high-conviction overweight status. Three key pillars will sustain the upbeat sales and profit backdrop for defense stocks. In sum, the souring global macro backdrop, rising policy uncertainty, melting real yields and a stampede into bonds all signal that it still pays to hold global gold miners as a portfolio hedge. First, the global arms race is alive and well and any governments seeking to augment their defense capabilities have to solicit the U.S. defense manufacturers. U.S. defense spending is rising at a healthy clip representing the major source of revenue growth for the industry (Chart 18). Defense capital goods orders have taken off and backlogs are at the highest level since 2012. The industry’s shipments-to-inventories ratio is also probing decade highs and weapons exports are near all-time highs (Chart 19). Chart 18Defense Spending Remains Upbeat Chart 19Healthy Operating Metrics Second, there is a space race going on with China and India working on manned missions to the moon, but recently President Trump signaled that he would like to beat both of these countries to the moon and in outer space. The defense industry also benefits when global space related demand is on the rise. Finally, cyber security remains a global threat and governments are serious about fighting it off decisively given the sensitivity of the data that cyber criminals are after. While defense stocks are not pure-play software outfits combating cyber criminals, recent industry tuck in acquisitions include such software companies in order for defense contractors to offer one-stop shop solutions to governments. Netting it all up, three key defense manufacturers’ demand drivers – global rearmament, a space race and cyber security – remain upbeat and will continue to underpin relative industry profitability. With regard to the financial health of the sector, balance sheets are pristine with net debt-to-EBITDA registering below the broad non-financial equity market and below 2x. Interest coverage is sky high at over 10x, again trumping the broad market. On the return on equity (ROE) front, defense stocks have the upper hand trading at an all-time high ROE of 39% or more than twice the broad market ROE (Chart 20). Looking at the valuation backdrop, relative valuations have corrected recently and defense equities no longer command a premium versus the overall market on both an EV/EBITDA and P/E basis (second & bottom panels, Chart 21). Chart 20Excellent Financial Standing Chart 21Valuations Have Corrected Netting it all up, three key defense manufacturers’ demand drivers – global rearmament, a space race and cyber security – remain upbeat and will continue to underpin relative industry profitability. Bottom Line: The BCA Defense Index remains a secular overweight and a high-conviction overweight. The ticker symbols for the stocks in the BCA Defense Index are: LLL, LMT, NOC, GD and RTN. Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com Footnotes 1 Please see BCA U.S. Equity Strategy Weekly Report, “Cracks Forming” dated June 24, 2019, available at uses.bcaresearch.com. 2 https://us.spindices.com/documents/index-news-and-announcements/2019062… 3 Please see BCA U.S. Equity Strategy Insight Report, “Locking In Homebuilder Gains” dated May 22, 2019, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Report, “The Good, The Bad And The Ugly,” dated March 4, 2019, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps
Highlights What did the Fed just do?: It cemented the tonal about-face it began signaling in March, pushing the start date of the next recession further out into the future. Why has the Fed pivoted so sharply?: It appears that the Fed has simply shifted its priorities, and decided that a little overheating is a small price to pay to stave off a potentially more troubling deflationary scenario. What does it mean for markets and the real economy?: Additional accommodation means that the expansion will last longer than it otherwise would have, and that the growth outlook will likely improve once rate cuts begin to make themselves felt. The former will extend the bull markets in risk assets, and the latter may well make prices climb at a faster pace. Dear Client, There will be no U.S. Investment Strategy next week as we take the first of two summer breaks. U.S. Investment Strategy will return on Monday, July 15th. We wish all of our northern hemisphere clients a happy start to the summer. Best regards, Doug Peta Feature We wrapped up the third of three weeks of travel to meet face to face with clients last week. The Fed was a constant topic of conversation across all three weeks, but there was a palpable mood shift in last week’s meetings. Investors appeared to be more at ease, partially because the uncertainty ahead of the FOMC meeting had been removed, but more so from the sense, as our U.S. Bond Strategy colleagues put it, that the Fed really does have their back. Trade tensions still loom as an unknown with potentially far-reaching consequences, but risk capital now has something to lean on as it navigates tricky geopolitical currents. That is not to say that the suspicion and distrust that has shadowed this expansion and bull market for ten years has entirely disappeared. There was plenty of discomfort in the unspoken what-does-the-Fed-know-that-we-don’t sense that underlay the why-has-the-Fed-turned-so-dovish question that we were asked in nearly every meeting. As long as that nervousness remains, the bull markets will still have a wall of worry to climb, and we won’t yet have transitioned to the final euphoric phase of the advance. We continue to recommend that multi-asset investors and managers of balanced portfolios remain at least equal weight equities and spread product. What Did The Fed Just Do? The Fed just signaled that it has fully transitioned from the tightening bias it had at the end of last year to an easing bias that may last to the end of this one. The dot plots of FOMC participants’ fed funds rate expectations demonstrate how the transition has unfolded over the last six months. At the December meeting, 15 of 17 participants expected rate hikes in 2019, and the median voter was calling for two hikes (Chart 1, top panel). By March, the median dot was down to zero hikes, as a net nine votes migrated from two and three hikes to zero (Chart 1, middle panel). The median dot narrowly remained at zero at the June meeting, but eight voters now see the Fed cutting rates this year versus a solitary holdout expecting a lone hike (Chart 1, bottom panel). As our Global Investment Strategy colleague Peter Berezin puts it, Recessions = (Imbalances + Rate Hikes). Unsustainable imbalances are the weak link in the economic chain and as such make an economy vulnerable. They can persist for longer than an observer diligently tracking them might expect (Dornbusch), but if they really can’t go on, they won’t (Stein). A restrictive monetary policy backdrop, typically set in place via a concerted rate-hike effort, is the stress that causes the weak link to snap, triggering the recession. We do not yet see any U.S. imbalances worthy of note in either the real economy or financial markets, and the Fed has signaled that it will most likely cut the fed funds rate in July. There is no such thing as a free lunch (Friedman), though, and the dovish shift boils down to a temporal trade-off in which future growth is pulled forward to the present. Unneeded monetary stimulus carries the seeds of its own demise via the promotion of inflation pressures and the animal spirits that are the mother’s milk of imbalances. Easier policy now will ultimately lead to a higher terminal fed funds rate later, but that higher peak is likely not even a story for next year, to judge by the 2020 dots. There will be a bill for unneeded stimulus down the road, but it shouldn’t color asset-allocation decisions now. Bottom Line: The Fed’s dovish pivot, sealed in last month’s FOMC meeting, will sustain the expansion for longer than we and most macro observers expected. The market status quo will likely hold for another couple years. Why Is The Fed Pursuing Easier Policy? We see three primary reasons for the Fed’s dovish turn: countering the domestic threat posed by a potential worsening of trade tensions, making conventional recession-fighting measures more robust, and insulating the expansion from market wiggles and popular concerns that could imperil it when amplified in social echo chambers. Global trade is a solid proxy for global growth. There is a longer lag before the comparatively closed U.S. economy is affected by global conditions than its major-economy peers, but there is no such thing as decoupling and global waves eventually wash up on its shores. Higher trade barriers would raise costs across the economy as outsourcing obstacles sent corporate wage bills shooting higher, tariff costs mainly fell on end-consumer households, and the disinflationary breeze that has drifted across the developed world since global sourcing became the rule was partially blocked (Chart 2). Higher trade barriers would also reduce corporate and household incomes as export opportunities were directly limited by tariffs and quotas, and indirectly limited by reduced foreign growth. Chart 2Globalization Has Been A Disinflationary Force The Fed first publicly turned in a dovish direction at the beginning of January in response to the material tightening in financial conditions imposed by the fourth quarter’s market selloffs. Although equities had retraced a good bit of their losses, and corporate bonds a good bit of their spread widening, by the end of the first quarter, the Fed became incrementally more dovish at the March FOMC meeting. At the time, Fed officials repeatedly cited the perils of inflation expectations becoming unanchored on the downside. Comparatively low inflation expectations mute the potency of conventional policy measures by making the zero lower bound on interest rates a more binding constraint. We took the Fed’s focus to mean that it was wary of entering the next recession with one arm tied behind its back (Chart 3), given our personal view that it is reluctant to embark on subsequent rounds of quantitative easing when markets have been so ticklish about its efforts to unwind a tiny portion of the initial ones. Chart 3ZIRP's Power Is Directly Related To Inflation We do not believe that the Fed has caved in to market expectations, as many commentators have argued. The Fed is indifferent to market gains and losses in themselves; it cares only about how those gains and losses impact the real economy via their influence over the aggregate economic state of mind. Rampant concerns about an inverted yield curve that led to a stock selloff and a significant bout of spread widening could have the effect of denting confidence among corporate management teams and households. If they circled the wagons, squeezing hiring, capital expenditures, and consumption, a decline in confidence could become a self-fulfilling prophecy, tipping the economy into a recession that would not have otherwise occurred. We do not believe that the Fed’s turn represents a capitulation to political pressures, either. There is a natural structural tension between elected officials facing recurring election cycles that are shorter than the business cycle from which central banks take their cue. The Johnson, Nixon, Reagan and Bush I administrations all leaned on the Fed, but only the Nixon administration succeeded in altering its behavior. In our view, the Fed’s independence remains intact. Bottom Line: Incremental monetary accommodation may not be necessary, strictly speaking, but the Fed has a sound basis for providing it, and investors should not worry that the Fed’s dovish turn is a sign that it knows about problems they don’t. What Does It Mean For Investors? From the perspective of the simple Berezin recession equation, the Fed has pushed the beginning date of the next recession further out into the future. One or two rate cuts will delay its progress toward lifting rates to a level that restricts economic activity. The imbalances that may currently be lurking in markets and the economy are modest enough that they can easily be sustained while monetary policy settings remain accommodative. Chart 5Yields May Be About To Turn We expect that incremental accommodation will eventually promote overheating, and the imbalances that accompany it, but that day is presumably a couple years and a sizable equity advance away, given how bull markets tend to sprint to the finish line (Chart 4). The 10-year Treasury yield tends to move with the global manufacturing PMI, and the series that lead it have turned sharply higher. We acknowledge that we have been on the wrong side of the duration divide, but the prospects for economic weakness that would push Treasury yields even lower are slim. As our U.S. Bond Strategy colleagues wrote last week, current data suggest that the U.S. is more likely to have been experiencing a mid-cycle slowdown than the initial stages of a recession.1 They have found that Treasury yields tend to move with the aggregate global manufacturing PMI, which remains quite weak. Gold prices and highly cyclical currencies’ performance versus the yen have a good record of leading the global PMI, however, and they have turned up, suggesting that economic pressure on yields will soon ease (Chart 5). A new round of rate cuts may be just what stocks need to end the bull market in their typical style. Recessions and bear markets tend to coincide, so pushing out the date when policy turns restrictive will have the effect of extending the equity bull market. The underlying rationale is fundamental – earnings almost always grow when the economy expands, supporting higher equity prices at equivalent multiples, and making sound borrowers even better credits – and argues for the continuation of the bull market in both equities and spread product. It may also have the animal-spirits impact of encouraging higher equity multiples and tighter credit spreads as the growth outlook improves, allowing the rate of the bull market’s advance to inflect higher. The earnings/multiple interaction may help explain bull markets’ tendency to stampede to the finish, and this one may not end until the climate turns euphoric. Stick around; the party doesn’t usually get going for a while yet. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “The Fed’s Got Your Back ”, dated June 25, 2019, available at usbs.bcaresearch.com.